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Sunday, August 24, 2014
"Price is what you pay, and value is what you get"
Even though this statement might seem overly simplistic for a person whose net worth is greater than several billion dollars, the Investment Committee would suggest that all investor memorize this phrase (perhaps even print out a copy and hang it on a wall).
For instance, let's say that we were to find an Armani sweater concealed in the racks at a discount retailer for 75% off the retail price, simply because there's a small hole within the fabric. We could purchase the sweater, fix the little hole, and then have a very nice sweater for a fraction of the price.
Comparable possibilities exist in equity markets, and value investing is predicated upon the concept that these markets overreact to negative information. In the example above, the Armani store overreacted to the small hole in a sweater and chose to dump it at an assumingly low price. Our savvy discount shopper realized the opportunity and purchased an asset that has been unfairly punished.
Stock prices often overreact in a similar manner and value investors who are able to see the opportunity and are patient enough to wait for a thesis to play out can realize substantial returns. The trick, on the other hand, is to take notice of the value as opposed to the price.
Value investors who make the mistake of concentrating on price alone often end up buying "value traps". These are stocks that screen cheap but are cheap for a reason. Let's say that the hole in the Armani sweater was swapped for a large discoloration on the back of a sleeve. Had our shopper not extensively evaluated the sweater, he would have bought something that would likely never be seen out in public.
To put it simply, value investors don't buy stocks because they are cheap, but rather for the reason that they signify a good value. Furthermore, their level of involvement will classify them into one of two types:
Passive: These investors buy value stocks and then wait for the value to be identified by the market. The Investment Committee employs a passive strategy with our investments.
Active: These investors see opportunity in stocks that they feel management is missing. They take an active role in the value creation and will frequently get aggressive if they feel that action is needed to get a company to change their ways.
Passive investing is relatively straightforward because it's not much more than a "buy and hold" strategy. On the other hand, active investing can be quite complex as well as highly aggressive at times.
Here's how it works:
The activist investor screens for undervalued companies and discovers exactly why a specific company is undervalued. If actions by management can make that value realized, they will acquire the stock. Some examples of potential management actions that can create value include spinning off subsidiaries or under performing divisions, using cash to buy back stock or paying a larger dividend, sell the company, etc.
NOTE: Most activist investors need considerable amounts of capital because they must purchase enough stock to be taken seriously. In most cases, an activist investor needs 5% or more of the shares outstanding to achieve the "muscle" necessary to fight with management.
Typically, the activist investor will meet with the management team of the company to make their case to unlock value within the enterprise. These conversations often go nowhere given a strong dislike towards change from management (think about the number of CEOs would welcome criticism from a third party party) or due to a fundamental disagreement on just how much value can be revealed.
If conversations with management are not constructive, then the activist investor will often publicly lobby the Board of Directors to adopt their proposed changes. The Board oversees company management and is established to serve in the best interest of shareholders. Thus, they have the ability to change managers and force some level of change when required.
If both the management team and Board resist an activist investor's idea(s), a "proxy fight" can arise. Essentially, the activist will lobby other large stockholders to attempt to get enough shareholder votes to force the Board to generate change. All in, the whole process could take years and require a tremendous amount of time, effort, and most of all patience.
To put it simply, the main difference between an active and passive investor is that although both strive to identify hidden value in a stock, an active investor will take part in unlocking that value whereas a passive investor leaves that job to the present management.
The Good, The Bad, & The Ugly
Activists are tenacious and will publicly fight with management for years when necessary. In fact, many will lobby government officials and even get litigious with Boards. Although many of their tactics may appear hostile, they serve a very important purpose in markets because managers realize that when they destroy shareholder value, activists will likely be there to step in and demand change.
For instance, the management team at Apple had been criticized for years over their exorbitantly large cash balance, which surpassed $150 billion at one point. Such a large cash balance sitting in the bank earns no interest, and financial theory states that if a company has no credible growth prospects they should give cash back to shareholders so they can redeploy that cash into better investments.
Even with shareholder frustrations, Apple was never the target of an activist until their stock fell from close to $800 down to $500 in a matter of months. The pressure on management continued to escalate to the point where two very well known activists, Carl Icahn and David Einhorn, got involved. Both investors are quite powerful on Wall Street and are savvy enough to know how to apply pressure to corporate management and Boards.
The end result has been a much more shareholder friendly Apple, where they now pay a strong dividend and have been buying back shares. The Investment Committee strongly agreed with the activists involved in Apple because the company was not acting in the best interest of shareholders who did not have as strong of a voice as Mr. Icahn.
Although this example with Apple shows the good in activists, there have been several scenarios where the bad, and even the ugly, has emerged. At the end of the day, activists are trying to make money and often their incentives are not aligned with the long-term health of a target company.
Activists have been known to fight to achieve short-term results that will cause only a temporary pop in the stock. The activist will then book a healthy profit by selling the stock with little regard to the long-term fundamental health of the company. Furthermore, activists tend to force managers to spend time and energy fighting them instead of dedicating their focus to running the business.
Implications for Investors
One of the most basic economic principles is that people are "self-interested". Meaning, our primary goal is to better our lives over the long run. Activists have clients that are paying them to grow their investment just as any investor would expect. Therefore, it's important to remember that these activists may make decisions that benefit their investors but hurt the shareholders of the companies they target.
Although activists may not always have their incentives aligned with their targets, they serve an important role in markets because they create a form of "checks and balances" with shareholders that are too small to have a voice. Managers who make repeated mistakes and destroy shareholder value should be held accountable, and if a Board is not acting in the best interest of its shareholders, then activists step in because they recognize value and will fight to unlock it.
The bottom line is that the Investment Committee applauds activists only when their efforts are intended to enhance the long-term benefit for the company and its shareholders.
(Article Credit: Global Financial Private Capital, Comprehensive Wealth Management, LLC)
Matt Golab is the Chief Advisor at Aaron Matthews Financial Resources. Matt Golab was recruited to write a chapter in Tom Hopkins recent book, Victory which became a National Best Seller. Matt also received the Editors Choice Award for his contribution to Victory, not every contributor is selected for this high honor. Matt is an authority on creating innovative tax and investment solutions to help his clients succeed in their retirement years. The strategies Matt Golab has established and passed on through successful financial planning with hundreds of clients over the years has launched him into the national spotlight. He is often featured in Retirement Advisor Magazine, a publication which attracts the top financial planners in the country. Matt has been featured in newspapers around the country passing on the principals for a successful retirement. Golab is often asked by national websites that focus on the education of consumers to present his knowledge on the areas of retirement and retirement income plans. Matt is frequently featured in The Wall Street Journal, CNBC, MSN Money, The San Francisco Chronicle, Newsweek, TheSmartRetiree, Burlington County Times and appeared nationwide on ABC, CBS, Fox, and NBC as well as USA Today. Golab is the Author of The Consumer's Guide to Planning Your Retirement: Your Guide to Mental Peace and Financial Well Being. Matt Golab continues to expand the geographic reach of his audience and desires to bring his expertise to a nationwide television audience. Matt emphatically states his mission, "I want to change the way Americans view their retirement. They can succeed (stay retired) regardless of what happens in the market". If you would like to ask a question or get contact info for Matt Golab, please click here. Investment Advisory Services offered through Global Financial Private Capital, LLC, an SEC Registered Investment Advisor.